Country risk

Scope of the firm in emerging marketsBenefits of conglomeration

• Focus is the mantra in New York/London. Good advice in emerging markets? Not necessarily. The scope of the firm depends on institutional context.

• What special in emerging markets– Info problem in financial, product, and labor markets. – Misguided regulation distorting markets– Inefficient judicial systems (contracts not reliably

enforced)

Financial marketsInfo problem and market failures

• W/o access to information, investors refrain from putting money into unfamiliar ventures. Developed markets minimize these problems thru institutional mechanisms:

– Reliable financial reporting– A dynamic community of analysts– An aggressive and independent financial press– SEC and other watchdog bodies– Shareholder rights are protected (securities litigation, proxy fights, and hostiles)– Venture capital firms specializes in assessing new opps.

• These institutions are largely absent or inefficient in emerging markets. Implications:– Investors refrain from investing.– Large and well-established firms have superior access to capital.– Diversification has value to investors. (Also to managers)– Diversified firms can also form internal capital market (internal finance)– Investors trust diversified groups to evaluate new opportunities and to exercise an auditing

and supervisory function.– Diversified firms imitate the institution features of venture capital firms, private equity

providers, mutual funds, banks, and auditors (independence??)

Product marketsInfo problems and market failures

• Cause of info problems– Underdeveloped communications infrastructure.– No mechanisms to corroborate claims made by sellers. (Consumer

Report in Russia?)– Consumer protection? Product safety regulation? Truth in advertising?

• Implications:– High cost in building credible brands in emerging markets

• But established brands wield tremendous power. – A conglomerate with a reputation for quality products and services can

use its group name to enter new businesses, even if those businesses are completely unrelated to its current lines.

– Groups can spread the high costs of building a reputation across multiple lines of businesses

– Groups also have the incentive to protect brand quality.• E.g., Samsung has used its name for a range of products ranging from TV,

microwave ovens, to computers.

Other market failures• Labor markets

– Problems • Lack of educational institutions to train people• No certification and screening • Labor regulation that limits layoffs

– Implications• Groups provide training programs (group specific)• Internal labor markets

• Regulation– Problems ---Too much regulations– Solution --- Groups as intermediaries between government and individual

companies. Lobbying, educating, (and bribing) politicians.• Contract enforcement

– Problems --- Contract not enforceable.– Solution --- Reputation for honest dealings

• Not every diversified group will be able to add value in the same way and no group can hope to fill every institutional void.

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Cost of equity for average projects in emerging markets

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Average monthly return

Standard deviation of

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Coefficient of correlation with world returns

Country beta

Sovereign spread

7/30/2001

Sovereign spread

1/29/2002COE

7/30/2001COE

1/29/2002

Argentina 0.00% 10.34% 0.58 1.34 12.58% 25.88% 26% 39%

Brazil 0.83% 12.39% 0.65 1.79 5.88% 7.29% 22% 23%

Colombia -0.67% 8.52% 0.19 0.35 6.41% 6.40% 14% 14%

Mexico 1.13% 9.59% 0.70 1.48 2.61% 2.22% 16% 16%

Venezuela 1.78% 13.27% 0.31 0.92 6.37% 13.02% 17% 24%

Hungary 1.60% 11.91% 0.56 1.48 0.62% 0.46% 15% 14%

Poland 0.55% 11.04% 0.49 1.20 0.63% 0.98% 13% 13%

Russia 3.89% 21.77% 0.51 2.46 5.81% 3.26% 26% 23%

Turkey 1.82% 19.72% 0.48 2.08 7.05% 5.20% 25% 23%

Korea -0.04% 17.22% 0.48 1.84 1.08% 1.22% 17% 17%

Malaysia -0.47% 13.87% 0.42 1.29 1.18% 0.94% 14% 14%

South Africa -0.18% 8.96% 0.61 1.22 2.11% 1.92% 14% 14%

Assumptions: Risk free rate = 5%, world market risk premium = 6%, COE = risk free rate + sovereign spread + country beta * world market risk premium (Lessard formula)

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Principles of Risk Management

Allocate risk to the party that controls the risk or had the greatest impact on its outcome (effectiveness).

When possible and cost effective to do so, write a detailed contract specifying actions, quality, and performance. Contracts work best when the risks are identifiable, outcomes are verifiable, and contracts are enforceable.

Predictable: note the difference between risk (known distributions) and uncertainty (unknown distributions)

Verifiable: note the role of asymmetric information.

Enforceable: note the importance of legal systems, property rights, and enforcement mechanisms.

Allocate risks to the party that can bear them at least cost (efficiency).

When negotiation, contracting, and other transaction costs make complete contracting unfeasible, allocate residual risk and return to align incentives and induce optimal behavior.

If possible, allocate asymmetric, downside risks to debt holders; allocate symmetric and upside risks to equity holders.

Why does project finance (or risk management) create value?

• Modigliani and Miller’s capital structure irrelevance proposition: under perfect capital markets, firm value should not depend on how a firm finance its investments.

• Real world capital markets are imperfect:– Taxes– Transaction costs– Costs of financial distress (bankruptcy)– Information costs (asymmetric information, managers know more than investors)– Incentive conflicts among managers, shareholders and creditors

• How project finance reduces the costs of market imperfection?– Reduce information costs by investing in tangible, transparent, and stand-alone

assets.– Reduce incentive conflicts

• Free cash flow conflicts --- require firms to raise external funds (debt) from independent third parties.

• Risk shifting (investing in high risk projects) --- “cash waterfall” to ensure creditors get the cash first.

• Generally, making decision makers bear the consequence of their decision.– Reduce financial distress

• Reduce the probability of distress -- risk contamination: independent entity• Reduce the costs of distress -- the tangible assets. Commodity products.

– Reduce corporate taxes